Sweating the small stuff | Law Gazette

The state of a rustic’s SME sector is a measure of its financial vigour. These companies are engine rooms that create jobs and current beneficial alternatives for entrepreneurship and innovation. Authorities statistics present that as of October 2023, there have been 5.6 million companies within the UK, 5,547,000 of which qualify as small (0-49 staff) or medium-sized (50-249), which means that 99.05% of UK companies are SMEs. Cultivating an SME shopper base gives attorneys with the chance to construct significant and lasting relationships.

Richard Cobb, head of company at south-west agency Michelmores, says: ‘It’s satisfying as a lawyer to steer a founder or administration staff from small startup via the scaling-up course of – via varied acquisitions, divestments, carve-outs – to the eventual exit, whether or not it is a sale or a inventory market itemizing.’

Tech M&A predominates

The emphasis on digital transformation within the office implies that expertise sector M&A is a selected focus. Regardless of the business, there’s a tech perform promising next-level enchancment: agritech, fintech, medtech, insurtech, cleantech (merchandise, processes or providers designed to cut back adverse environmental impacts) and deeptech (multidisciplinary tech improvements aimed toward fixing world challenges resembling local weather change).

As an alternative of constructing their very own tech capabilities, acquirers can rapidly achieve entry to proprietary expertise that permits them ‘first mover’ benefit. By specializing in such vertical integration, acquirers not solely elevate their very own tech however decrease prices and simplify enterprise observe by gaining management over the provision chain.

An instance of a profitable insurtech deal was RVU’s acquisition of Tempcover, a web-based platform that gives non permanent insurance coverage options, from specialist non-public shopper various investor Connection Capital. Freshfields suggested RVU, the proprietor of Confused.com, USwitch.com and Cash.co.uk; industrial agency Gateley suggested Connection Capital, having steered Tempcover all through its funding cycle from MBO to follow-on funding and eventually to its exit.

Deeper due diligence required

With the factitious intelligence (AI) revolution, companies that concentrate on AI, machine studying, deep studying and the ‘web of issues’ are in demand, notably in sectors resembling healthcare. Expertise that makes use of information mining, picture processing and predictive modelling to generate actionable insights is gold mud to potential enterprise companions resembling pharma firms.

But the sooner expertise evolves, the extra uncertainty is launched into the deal course of. For instance, placing a worth on a enterprise with seemingly limitless potential is troublesome, and there are sometimes variations of opinion. The rise in earn-out offers – contractual provisions permitting the vendor of the enterprise to acquire extra compensation if that enterprise achieves sure monetary objectives – is a consequence of this uncertainty. Earn-out provisions have gotten more and more advanced and creatively structured, reaching past measuring return on funding.

The tempo of technological change has additionally created a necessity for deeper – and extra intrusive – due diligence. Legal professionals should perceive the exact perform of the tech in query to find out whether or not a notification is required beneath the Nationwide Safety and Funding Act 2021. Generally an unbiased professional is enlisted to analyse a goal’s services earlier than the deal can progress.

‘Expertise companies have gotten so superior that attorneys, who are usually not business consultants, can generally attain the boundaries of their cognitive skills in understanding them,’ says Kingsley Napley’s Glafkos Tombolis, who often advises on healthcare information M&A transactions, and company and enterprise homeowners working within the cybersecurity, enterprise software program, retail and digital advertising sectors. ‘However it’s essential to work out precisely what the goal does to evaluate whether or not it falls throughout the ambit of the act.’

Earlier than the Nationwide Safety and Funding Act got here into power in 2021, the flexibility of the federal government to intervene in transactions was circumscribed and solely doable via restricted provisions within the Enterprise Act 2002.

Now, if the deal falls inside 17 specified administration sectors and the client doesn’t make a compulsory notification when required, a felony offence is dedicated and the enterprise can incur heavy fines, in addition to having the deal voided. There is no such thing as a materiality threshold, and the act covers investments in addition to acquisition of management.

Tombolis says: ‘The act impacts the deal timetable in needing to construct in time to inform, wait, obtain a authorities assessment, then probably mitigate and supply cures. It’s a draconian and really consequential piece of laws – with the ability to utterly wreck transactions and make the enterprise case for the deal much less sure.’

Prolonged due diligence is not only a function of tech offers. ‘There are extra complexities in M&A offers referring to monetary preparations and the vary of capital options used,’ says Nigel Taylor, company and M&A accomplice at London agency Wedlake Bell. ‘Offers are taking longer, because the events are usually not simply kicking the tyres however lifting the bonnet.’

Environmental, social and governance

The rise in EU ESG-related regulation, along with the reputational danger of unfulfilled or deceptive sustainability commitments, imply that deeper due diligence probes are extra vital than ever (see ‘Seeing and believing’, Gazette, 14 June).

An acquirer ought to look at a goal’s ESG insurance policies and procedures to examine they’re sturdy, in addition to analysing their sanctions and exports controls and cybersecurity. The place there are advanced provide chains in play, there’s a potential danger of governance breaches, corruption, bribery and fraud. All these components are beneath extra scrutiny from guarantee and indemnity insurers, with an affect on negotiation over the scope of warranties drafted.

The Financial Crime and Company Transparency Act 2023 can be related right here. Acquirers won’t need to find yourself within the line of fireside for the brand new ‘failure to forestall’ offence for fraud, anticipated to come back into power in early 2025. The act additionally incorporates adjustments to the identification precept required for prosecution. Reasonably than figuring out the person who’s the ‘directing thoughts and can’ of the entity, it’s now enough to determine a accountable ‘senior supervisor’. This poses an additional layer of danger for the acquirer.

‘Technological innovation and its interface with nationwide safety, along with ESG concerns, are gumming up the deal course of and making them extra protracted and sophisticated, with a rising must draft thorough walkaway rights,’ says Tombolis.

However ESG presents a possibility in addition to a danger. Sturdy ESG credentials in a enterprise are more and more fascinating. They’re perceived as an indication of a optimistic working tradition, excessive workers retention, and dedication to model and repute.

Gross sales to workers, the place staff maintain vital possession within the enterprise via worker share possession plans, employee cooperatives or mutuals, are additionally growing. Tombolis notes: ‘Worker possession trusts is usually a useful gizmo for democratising the enterprise and enhancing ESG credentials. They’re additionally tax environment friendly as a result of the sale doesn’t crystallise CGT.’

ESG information and reporting have gotten important throughout each enterprise sector up and down the provision chain. Thus, companies that concentrate on ESG and sustainability have develop into beneficial acquisition targets. One instance is London-based sustainability advisory and options agency Anthesis, during which non-public fairness investor Carlyle Capital is a majority shareholder. Anthesis has made six ESG acquisitions up to now 18 months. The newest was ‘purpose-driven’ advertising firm Revolt, which helps the C-suite with initiatives throughout sustainability, DEI technique and communications.

Personal fairness

In December 2023 S&P International estimated that non-public fairness was sitting on round $2.6 trillion of capital prepared for deployment. Pushed by the necessity to create deal stream and produce returns for restricted companions, non-public fairness has turned to SMEs, which have the benefit of agility, the potential to develop rapidly, and, as lower-value companies, might be bought with out giant ranges of debt – essential at a time of upper rates of interest.

UK-based non-public fairness investor LDC, the non-public fairness arm of Lloyds Banking Group, is a working example. Investing £350m into UK-based SMEs in 2023, LDC introduced that it was planning to develop that determine in 2024. Final 12 months LDC invested £300m in 14 new companies and offered £50m of follow-on funding to its present portfolio of greater than 90 firms, in addition to supporting 46 bolt-on acquisitions. New investments included sustainability information and expertise supplier Sedex, specialist product company Star Stay, AI-based expertise analytics platform Horsefly and managed service supplier DSP.

Shopping for bolt-ons is important to the ‘buy-to-build’ methods presently utilized by non-public fairness traders to ship progress. On this situation a platform firm is used to make round 4 or extra sequential add-on acquisitions of smaller firms, with SaaS (software program as a service) additions proving notably in style. The SME market is the place to search out these alternatives.

Cashing in

Having battled adversarial circumstances over the previous few years, it’s no shock that some owner-managers need out. Sellers make investments appreciable time and assets in exit methods, together with implementing sturdy firm insurance policies and procedures, reviewing tax positioning, and creating efficient succession planning.

At the moment, there’s an urge for food amongst worldwide acquirers scoping out the UK SME market. ‘EU firms which have discovered it troublesome to entry UK markets after Brexit are in search of acquisitions,’ says Tombolis. ‘There’s additionally appreciable curiosity from US patrons, given the energy of the greenback in opposition to the pound.’ It stays to be seen whether or not there will probably be a flurry of UK offers with a US nexus closing earlier than the US election in November. With greater than 40 elections scheduled world wide in 2024, political upheaval can considerably have an effect on deal stream, relying on the enterprise sector and jurisdictions coated.

Trying forward

The looming UK common election has had an affect on SMEs. Some are eager, their advisers report, to get offers over the road earlier than an anticipated Labour victory. Others at formative deal levels want to attend and see. Legal professionals report that SME purchasers are apprehensive about doable adjustments in tax insurance policies or rules that will have an effect on deal phrases.

Labour said in March that it has no plans to extend capital features tax. It additionally dominated out rises to earnings tax, nationwide insurance coverage and company tax. A priority for SMEs is that, even within the occasion of no direct tax rises, reliefs (resembling on enterprise asset disposal) will probably be eliminated. Any adjustments to taxes or reliefs are prone to trigger a rush of exercise within the SME M&A market, akin to when the lifetime restrict on entrepreneurs reduction was lowered from £10m to £1m in 2020.

AI laws might additionally have an effect on offers. The final authorities’s AI white paper, printed in March, set out its ‘pro-innovation’ strategy. This contrasts with the EU’s plan to introduce a stricter statutory framework beneath its proposed Synthetic Intelligence Act. If the differing approaches to AI regulation throughout jurisdictions come to move, there are prone to be additional due diligence challenges on cross-border M&A offers which can lengthen timeframes. Extra teamwork between attorneys, owner-managers, administration groups and tech-sector specialists could also be essential to push an AI-focused M&A deal over the road.

All this comes in opposition to adversarial headwinds in world markets, extra distressed offers, reorganisations and sure carve-outs. The attraction of AI and its adjoining applied sciences will solely develop, whereas the continuing discount within the numbers of expert employees – essential to the operation of many companies within the SME sector – might result in SMEs that supply the potential to realize operational efficiencies via AI being probably the most extremely prized targets.

Katharine Freeland is a contract journalist